The Muni-Bond Meltdown: Sell First, Ask Questions Later

Anyone seeing a chart like the one a few paragraphs below in recent days is probably wondering whether the recent “muni-bond meltdown” is a harbinger of things to come.

Surging yields have been one of the dominant themes of recent weeks and some think that the rapid rise in borrowing rates for many states and municipalities – many of which have deeply troubled finances – is the proverbial “canary in the coal mine”, signaling that interest rates have nowhere to go but up and that the European sovereign debt crisis is about to be repeated here in the U.S. with Michigan and California playing the roles of Greece and Spain.

We will see…

At the moment it appears that a number of factors have converged to cause investors to panic – sell first and ask questions later – but credit markets saw strong demand late last week at reduced prices (and higher yields) that reversed some of the losses earliy on.

There is no doubt that, since the election in which Republicans were ceded control of the House of Representatives, this market has been a scary place.

Tom Dresslar, a spokesman for the California State Treasurer commented on Wednesday after the state withdrew a bond offering, “The tax-exempt municipal bond market is a cold, cold world right now for issuers and taxpayers”.

After pouring money into muni-bonds for months, redemptions totaled nearly $3 billion just last week – the highest in 19 years – following the first weekly outflow in seven months of $115 million the week before. As should be clear in the graphic below depicting the $2.1 billion iShares S&P National AMT-Free Municipal Bond ETF (NYSE:MUB), muni-bonds have been a popular option for investors this year – until early this month.

Of course, it didn’t help last week that Moody’s Investors Service downgraded the cities of San Francisco and Philadelphia along with the small Michigan city of Hamtramck, in this case, by request in order that the town could file for bankruptcy.

Some funds that buy tax-exempt munis have dropped as much as 8 percent since the election and, to the surprise of many, some of the ETFs traded below their net asset value (i.e., below the value of the underlying bonds), an indication of how severe the selling has been. On both Monday and Tuesday last week, the iShares ETF shown above closed more than 2 percent below the value of the bonds it owns.

Rising long-term interest rates, $10+ billion in new bond offerings from financially strapped California, and a glut of new supply from other states and issuers for BAB (Build America Bonds) before this government program expires at the end of the year have all factored into the recent rout. BABs are taxable bonds in which the interest is subsidized by the federal government to the tune of 35 percent and, with Republicans retaking the House of Representatives, it has become more likely that this program will not be extended and aid flowing from Washington to the states is likely to become much more difficult.

More than $150 billion in BABs have been issued through the end of October according to the Treasury Department and states are now rushing to secure more of this financing before year-end. Last week, California shifted almost $2 billion from typical tax-deferred municipal bonds to BABs as rates soared, however, this option will likely not be available in the new year.

So, what does all this mean?

It is unclear at the moment, but, the more you think about it, the more the United States is starting to look like Europe where states may have increasing difficulty financing their debt without the implied guarantee of a central authority. Had the ECB abandoned Greece and Ireland earlier in the year, who knows what things would look like in Europe and, with a new and very different Congress about to take over in January, who knows what things will look like in California next year.

Some are now speculating that the Federal Reserve might soon step in to buy municipal bonds, however, that would be a clear violation of their charter. Then again, they could probably invoke the “clear and exigent” clause once again in order to bail out the states as they did when they bailed out Wall Street banks and related firms two years ago.

It looks like 2011 is shaping up to be an exciting year for state and local governments.

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